The Motley Fool

One very big concern for Medibank Private buyers

The IPO of leading health insurance business Medibank Private has received enormous attention from investors and analysts. After roughly 750,000 people lodged their pre-registration interest in the IPO, interest once again peaked on Monday as the retail offer of shares opened up to mum and dad investors in what could certainly prove to be the biggest privatisation since Telstra Corporation Ltd (ASX: TLS).

Given the high level of excitement, the shares are likely to open at the upper end of their ‘indicative’ price, currently said to be between $1.55 and $2.00. Of course, retail investors who take part in the IPO are lucky in that their shares will be capped at $2.00, no matter the price that institutional investors will be required to pay.

So let’s assume that the shares do open at $2.00. That will have the stock trading on a forecast P/E ratio of roughly 21.3 times earnings. That’s very high considering other insurers, such as NIB Holdings Limited (ASX: NHF) and Insurance Australia Group Ltd (ASX: IAG), are trading on multiples of 18.9x and 12.6x, respectively.

But that’s not the biggest issue. Instead, the company’s growth prospects have also come under scrutiny which is cause for much greater concern for investors.

The very big concern…

While the business and the nature of Medibank’s IPO has received significant attention, the insurer’s sizeable investment portfolio has largely been ignored. Last year, Medibank Private generated 22% of its profit from its $2.2 billion investment portfolio – 18% of which is dedicated to growth assets while the rest is in more conservative asset classes.

Of course, this structure has benefited Medibank enormously in recent years as the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) has charged to multi-year highs, but it also leaves the company exposed to a high risk of underperformance from equities. Even if the market doesn’t tank (I’m not one to even attempt to predict a market crash), Medibank’s investment income remains partly leveraged to the stock market. Indeed, this will have a direct impact on the group’s overall profits, too.

To expand on the subject of growth prospects, Motley Fool investment analyst Matt Joass put it perfectly last week when he said:

“Despite the company’s dominant market position and growth, most of the excitement around the IPO comes not from what Medibank is doing very well, but from what it’s doing poorly.”

In order to justify its high valuation, Medibank would need to successfully cut costs and improve its underwriting margins, which are currently lagging behind those of its primary rivals. The insurer is also constrained by the government on how much it can raise its premiums which could also stunt earnings per share growth further.

It would be unreasonable to expect those fixes to occur overnight and could instead take some time for the company to deliver on the market’s high expectations. This could certainly see shares drop in the medium term.

Although there is a high level of excitement surrounding this IPO, my most likely course of action will be to remain on the sidelines and see how the situation plays out over the coming months. I really don’t see there being a drastic need to rush in and will continue to consider the plethora of other attractive investment opportunities presenting themselves in the meantime.

5 stocks under $5

We hear it over and over from investors, "I wish I had bought Altium or Afterpay when they were first recommended by The Motley Fool. I'd be sitting on a gold mine!" And it's true.

And while Altium and Afterpay have had a good run, we think these 5 other stocks are screaming buys. And you can buy them now for less than $5 a share!

*Extreme Opportunities returns as of June 5th 2020

Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

Related Articles...

Latest posts by Ryan Newman (see all)